The capital shortfall at EU banks is 8% higher than originally thought, according to the latest assessment from the European Banking Authority. This column examines the evolution of loan-to-deposit ratios in big European banks. It says banks have been buying back their debt securities, hoarding profits, limiting bonuses, and deleveraging. However, write-downs of sovereign debt have largely offset these efforts.

The capital shortfall at EU banks is 8% higher than originally thought, according to the latest assessment from the European Banking Authority (EBA 2011) released on 8 December. In the aggregate, European banks need to raise €114.7 billion as an exceptional, temporary capital buffer against sovereign debt exposures and to ensure their individual Core Tier 1 capital ratio reaches 9% of risk-weighted assets by the end of June 2012.

The EBA tests indicate that approximately one-third of banks sampled need stronger capital reserves to meet the June 2012 deadline. In particular, the EBA finds that banks in Italy and Spain will need to raise significantly more capital, while French banks have already built up sufficient reserves to buffer against potential sovereign bond write-downs. German banks have a capital shortfall of €13.1 billion, which is three times the amount originally estimated in October, although this is still small relative to the size of its banking system. In contrast, banks in Ireland, Luxembourg, Sweden, the UK, and six other countries require no additional capital.

Some investors may be relieved that the overall recapitalisation figure is not higher in light of growing concerns over the Eurozone, but others may be surprised that the gap has not been reduced already. In the last two months, banks have taken a number of important steps to bridge their capital shortfall, such as buying back their debt securities, hoarding profits, limiting bonuses and dividend payments, converting some debt to equity-like instruments, and, of course, deleveraging. However, write-downs of sovereign debt have largely offset those efforts.

Deleveraging with a capital D

In a press statement accompanying the publication of its capital assessment, the EBA stated that deleveraging could only be used in part to achieve a firm’s capital targets, and only in cases where assets had been transferred to a third party (and not just dumped), to ensure the flow of lending was kept constant in the real economy. While difficult to enforce, this intent is sound; wholesale deleveraging could trigger a vicious spiral, with a reduction in lending decreasing economic activity which would, in turn, damage banks’ balance sheets and result in a need for additional capital.

The deleveraging process has already begun in earnest. Banks in France, the UK, Ireland, Germany, and Spain have already unveiled plans to slash a total of €775 billion of assets in the next year, according to data collected by Bloomberg.

Specifically, the bank with the biggest single gap to close according to the EBA, Santander, has taken a number of steps to address its capital shortfall, including selling a number of its profitable businesses in Latin America. Figure 1 illustrates the dramatic (and not so dramatic) falls in the loan-to-deposit ratio of 20 European banks in the last 9 months.

Figure 1. Loan-to-deposit ratios of selected European banks, March to September 2011

Source: Bloomberg

Figure 1 is a slopegraph, allowing a comparison of changes over time for a list of selected banks and their loan-to-deposit ratios located on an ordinal scale. When read vertically, the chart ranks 20 European banks’ loan-to-deposit ratios as they were in March, June, and September of 2011, with the names spaced in proportion to the percentages. Across the columns, the paired comparisons show how the loan-to-deposit ratios changed over the nine-month period. Data are from Bloomberg.

We can clearly see the deleveraging taking place within banks like Commerzbank (137 to 123) or DNB (175 to 167), and we can see other banks with much larger loan-to-deposit ratios with less deleveraging taking place, like Danskebank (217 to 213), Swedbank (228 to 217), and Svenska (240 to 222). Even within this sample, there are clearly risks to deleveraging, and banks proceeding at different paces.

Many analysts believe, however, that this deleveraging is just a start, and European banks will have to reduce their balance sheets by €1.5 to €2.5 trillion over the course of the next 18 months to meet more stringent capital requirements, according to research from Morgan Stanley (2011). Many private equity firms and hedge fund managers are eying up opportunities for bargains in 2012 on the back of anticipated deleveraging (The Economist 2011). Others believe the correction will be more protracted, probably drawn out over a ten-year period and with a trajectory similar to Japan’s financial woes during the 1990s.

So far, most assets have been sold at close to market value, and it seems unlikely that banks (or indeed, governments) will let assets go at any price in an effort to raise capital in the short run. This stand-off raises the probability of public bailouts in 2012 for a number of weaker Eurozone banks in particular, as they face a number of other challenges in raising capital through private sources.

First, management may hesitate to raise capital through a rights issue given the depressed nature of their stock— the average European bank’s equity is trading at only about 60% of its book value. The debt market is volatile and we have seen some large players unwilling to rollover dollar-denominated debt to European banks in recent months. While investors will return to this market as they search for higher yields when market conditions stabilise, European banks, as it currently stands, already have significant short-term funding refinancing needs. According to analysts, European banks must rollover around €1.7 trillion of senior debt of more than a year’s maturity over the course of the next three years, which could leave little room to raise additional capital.

While banks’ retrenchment strategies may be the only viable option for meeting the new requirements through private means, there is a concern that this will reduce lending in the real economy and dampen any meaningful economic recovery. The situation highlights the complexity of the interdependence between banks and public revenues. A strong banking system helps stimulate private investment in the economy which in turn generates taxable revenues. European firms rely on banks for as much as 80% of their funding, compared with only 30% for US firms (Financial Times 2011). Similarly, if governments restore the long-term sustainability of their public finances, the risk premium on banks’ exposures to sovereign debt will be reduced, bringing down the need for additional capital at banks.

Bridging the gap: The inevitability of government support

Given all these factors, it is highly probable that national governments will have to step in and provide some form of temporary support if their systemic banks are unable to raise capital at sustainable rates. The European Commission (2011) is planning for this eventuality, and has recently updated and extended its state-aid rules and accompanying support framework for banks in the context of the financial crisis. As a result, the Commission’s Banking Communication, Recapitalisation Communication, Restructuring Communication and Impaired Assets Communication will all remain in place during 2012, due to the increased financial tensions caused by the sovereign debt crisis. Moreover, in view of the changing regulatory and market landscape, the Commission anticipates that, in the future, capital injections by member states are more likely to take the form of shares bearing a variable remuneration, and has provided some clarification on the pricing rules for capital injections.

While this gives greater freedom for governments to support their banking sector next year (relative to other industries), supported entities will still be subjected to pretty stringent conditions. In March 2011, following negotiations between the Commission and the Irish government, state-supported Bank of Ireland and Allied Irish Bank were required to sell off €53 billion of assets by 2013 to comply with state-aid rules. In the UK, following the injection of public funds into its banking system in 2008-9, Royal Bank of Scotland had to divest £251 billion of assets from its balance sheet and engage in a significant restructuring programme. Similarly, Lloyds Banking Group is required to dispose of over 600 branches to limit the distortions of competition brought following its state-sponsored acquisition of Halifax Bank of Scotland in 2008.

Banks which are vulnerable will note these cases and push hard to raise capital in the year ahead, to avoid ending up in state-aid scenarios. A forced public bailout would have serious ramifications for a bank’s long-term strategy, remuneration policy and underlying profitability. Public sentiment has turned against government bailouts in the past two years, and as a result politicians may be more inclined to let institutions fail, rather than shoring them up with public money, than they were a couple years ago.

The current patchwork framework on state-aid rules for the banking system will not remain in place in the longer term. The Commission will keep the situation in the financial markets under review and will take steps towards more permanent rules for state aid used for rescue and restructuring of banks, as soon as market conditions permit. All this means EU banks would be well advised to address any capital shortfalls now.